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12 Dec 2019

If the auditor concludes that the client's inventory turnover ratio is LOWER than the industry average, this could mean that:

a.

inventory may be slow moving or obsolete
b.

The client's "days of inventory on hand" will be lower as well
c.

both of the above
d.

neither of the above

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Analytical Data for Jones Manufacturing

Prior Period 000 omitted

% of Sales

Current Period 000 omitted

% of Sales

% Change

Industry Average as % of Sales

Sales

$10,000

100

$11,000

100

10

100

Inventory

$2,000

20

$3,250

29.5

57.5

22.5

Cost of goods sold

$6,000

60

$6,050

55

0.83

59.5

Accounts payable

$1,200

12

$1,980

18

65

14.5

Sales commissions

$500

5

$550

5

10

N/A

Inventory turnover

6.3

—

4.2

—

(33)

5.85

Average number of days to collect

39

—

48

—

23

36

Employee turnover

5%

—

8%

—

60

4

Return on investment

14%

—

14.3%

—

2.1

13.8

Debt/Equity

35%

—

60%

—

71

30

Assume that the auditor expected that the client’s performancein the current year would be similar to its performance in theprior year.

Select the potential risk factor that matches the risk analysisdescribed.

Accounts payable increase

Average number of days to collect

Cost of goods sold decrease

Debt/equity ratio

Employee turnover

Inventory increase

Inventory turnover

Return on investments

Risk Analysis

Potential Risk Indicator

a.

Has decreased by 33 percent. This points to and confirms theproblems identified by the increase in inventory and decrease incost of goods sold. There are substantial obsolescence problems,material items are not correctly recorded. Or the inventory hasbeen intentionally increased in anticipation of some unusual eventearly next year as mentioned in the accounts payable increase.

b.

This ratio has increased substantially and is double theindustry average. The company has become highly leveraged. Theincreased leverage has three implications the auditor ought toaddress: the existence of new debt covenants that ought to beaddressed as part of the audit; a potential problem of remaining agoing concern should there be a downturn in operations or asignificant increase in interest rates; there may be concern withhow the debt proceeds have been utilized by the company.

c.

The increase could reflect credit problems or other financingproblems. Such problems could make it difficult for the company tocarry out its on-going activities. It may simply reflect thepurchase of an unusual amount of inventory just beforeyear-end.

d.

This ratio has increased by 23 percent over the previous yearand is 33 percent above the industry average. The increase in theratio could represent a number of problems: less stringent creditstandards; warranty problems; unrecorded returned items or asignificant lag in issuing credit memos associated with returneditems.

e.

There is a substantial increase both in dollar terms and as apercentage of sales, which could indicate potential problems withnew products, with obsolescence, or with competitiveness with otherproducts. It may indicate an increase of just before year-end inanticipation of rise in cost, a strike, or unusually heavy demand.Could be overstated due to misstatements of quantities or prices.This could also affect the COGS change.

f.

This ratio does not indicate a problem. In fact, the companyexceeds the industry average. An alert auditor should wonderhowever, how the company is able to maintain a superior return whenthere are problems with inventory and receivables.

g.

Has decreased to 55 percent of sales at the same time inventoryhas increased. One explanation is that costs have not been bookedfor some significant sales. There may also be a change in productmix.

h.

This is more difficult to interpret, but there is a 60 percentincrease over previous years to a rate that is double that of theindustry. This might indicate problems with morale, qualitycontrol, or other dissatisfaction with the manner in which thecompany is being run.

Jones Co. is in a technology-intensive industry. Recently, oneof its competitors introduced a new product with technology thatmight render obsolete some of Jones's inventory. The accountingstaff wants to follow the appropriate authoritative literature indetermining the accounting for this significant market event.

Instructions

(a) Identify the primary authoritative guidance for theaccounting for inventories.

(b) List three types of goods that are classified as inventory.What characteristic will automatically exclude an item from beingclassified as inventory?

(c) Define “market” as used in the phrase“lower-of-cost-or-market.”

(d) Explain when it is acceptable to state inventory above costand which industries allow this practice.

34
The following audit procedures were performed in the audit of
inventory to satisfy speci(c balance-related audit objectives as
discussed in Chapter 6. The audit procedures assume that the
auditor has obtained the inventory count sheets that list the client’s
inventory. The general balance-related audit objectives from
Chapter 6 are also included.
Audit Procedures
1. Test extend unit prices times quantity on the inventory list, test foot
the list, and compare the total to the general ledger.
2. Trace selected quantities from the inventory list to the physical
inventory to make sure that it exists and the quantities are the same.
3. Question operating personnel about the possibility of obsolete or slow-
moving inventory.
4. Select a sample of quantities of inventory in the factory warehouse and
trace each item to the inventory count sheets to determine if it has
been included and if the quantity and description are correct.
5. Compare the quantities on hand and unit prices on this year’s
inventory count sheets with those in the preceding year as a test for
large di5erences.
6. Examine sales invoices and contracts with customers to determine
whether any goods are out on consignment with customers. Similarly,
examine vendors’ invoices and contracts with vendors to determine
whether any goods on the inventory listing are owned by vendors.
7. Send letters directly to third parties who hold the client’s inventory and
request that they respond directly to the auditors.
General Balance-Related Audit Objectives
Existence Cuto5
Completeness Detail tie-in
Accuracy Realizable value
Classi$cation Rights and obligations
Required
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general balance-related audit objective or objectives
satis$ed by each audit procedure

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